WASHINGTON – Two global banks and more than a dozen hedge funds misused a complex financial structure to claim billions of dollars in unjustified tax savings and to avoid leverage limits that protect the financial system from risky debt, a Senate Subcommittee investigation has found.

The improper use of this structured financial product, known as basket options, is the subject of a 93-page report released by the Chairman and Ranking Member of the U.S. Senate Permanent Subcommittee on Investigations, Senator Carl Levin, D-Mich., and Senator John McCain, R-Ariz., and will be the focus of a Tuesday hearing at which bank and hedge fund officials and tax experts will testify.

“Over the years, this Subcommittee has focused significant time and attention on two important issues: tax avoidance by profitable companies and wealthy individuals, and reckless behavior that threatens the stability of the financial system,” said Levin. “This investigation brings those two themes together. These banks and hedge funds used dubious structured financial products in a giant game of ‘let’s pretend,’ costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation.”

“Americans are tired of large financial institutions playing by a different set of rules when it comes to paying taxes,” said McCain. “The banks and hedge funds involved in this case used the basket options structure to change the tax treatment of their short-term stock trades, something the average American investor cannot do. Hedge funds cannot be allowed to have an unfair tax advantage over ordinary citizens.”

The report outlines how Deutsche Bank AG and Barclays Bank PLC, over the course of more than a decade, sold financial products known as basket options to more than a dozen hedge funds. From 1998 to 2013, the banks sold 199 basket options to hedge funds which used them to conduct more than $100 billion in trades. The subcommittee focused on options involving two of the largest basket option users, Renaissance Technology Corp. LLC (“RenTec”) and George Weiss Associates.

The banks and hedge funds used the option structure to open proprietary trading accounts in the names of the banks and create the fiction that the banks owned the account assets, when in fact the hedge funds exercised total control over the assets, executed all the trades, and reaped all the trading profits.

The hedge funds often exercised the options shortly after the one-year mark and claimed the trading profits were eligible for the lower income tax rate that applies to long-term capital gains on assets held for at least a year. RenTec claimed it could treat the trading profits as long term gains, even though it executed an average of 26 to 39 million trades per year and held many positions for mere seconds.

In 2010, the IRS issued an opinion prohibiting the use of basket options to claim long-term capital gains. Based on information examined by the subcommittee, tax avoidance from the use of these basket option structures from 2000 to 2013 likely exceeded $6 billion. In addition to avoiding taxes, the structure was used by the banks and hedge funds to evade federal leverage limits designed to protect against the risk of trading securities with borrowed money. Leverage limits were enacted into law after the stock market crash of 1929, when stock losses led to the collapse of not only the stock speculators, but also the banks that lent them money and were unable to collect.

Had the hedge funds made their trades in a normal brokerage account, they would have been subject to a 2-to-1 leverage limit – that is, for every $2 in total holdings in the account, $1 could be borrowed from the broker. But because the option accounts were in the name of the bank, the option structure created the fiction that the bank was transferring its own money into its own proprietary trading accounts instead of lending to its hedge-fund clients.

Using this structure, hedge funds piled on exponentially more debt than leverage limits allow, in one case permitting a leverage ratio of 20-to-1. The banks pretended that the money placed into the accounts were not loans to its customers, even though the hedge funds paid financing fees for use of the money. While the two banks have stopped selling basket options as a way for clients to claim long-term capital gains, they continue to use the structures to avoid federal leverage limits.

Data provided by the participants indicates that basket options produced about $34 billion in trading profits for RenTec alone, and more than $1 billion in financing and trading fees for the two banks.

“These basket option deals were enormously profitable for the banks and hedge funds that used them,” Levin said. “But ordinary Americans have shouldered the tax burden these hedge funds shrugged off. Those same ordinary Americans would pay another price if the reckless borrowing outside of federal safeguards were to blow up.”

The Levin-McCain report includes four recommendations to end the option abuse.

• The IRS should audit the hedge funds that used Deutsche Bank or Barclays basket option products, disallow any characterization of profits from trades lasting less than 12 months as long-term capital gains, and collect from those hedge funds any unpaid taxes.• To end bank involvement with abusive tax structures, federal financial regulators, as well as Treasury and the IRS, should intensify their warnings against, scrutiny of, and legal actions to penalize bank participation in tax-motivated transactions. • Treasury and the IRS should revamp the Tax Equity and Fiscal Responsibility Act regulations to reduce impediments to audits of large partnerships, and Congress should amend TEFRA to facilitate those audits.• The Financial Stability Oversight Council, working with other agencies, should establish new reporting and data collection mechanisms to enable financial regulators to analyze the use of derivative and structured financial products to circumvent federal leverage limits on purchasing securities with borrowed funds, gauge the systemic risks, and develop preventative measures.

Tuesday’s hearing is at 9:30 a.m. in Room 216 of the Hart Senate Office Building. Witnesses will be:

Panel 1: Steven Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center; and James R. White, director of tax issues for the Government Accountability Office.